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Sunday, October 26, 2008

New, sounder system will emerge

Former Federal Reserve chairman Alan Greenspan testified before a US congressional committee on Thursday on the financial crisis. We carry an edited excerpt of his prepared statement.

WE ARE in the midst of a once-in-a century credit tsunami. Central banks and governments are being required to take unprecedented measures.

In 2005, I raised concerns that the protracted period of underpricing of risk, if history was any guide, would have dire consequences. This crisis, however, has turned out to be much broader than anything I could have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount.

Given the financial damage, I cannot see how we can avoid a significant rise in layoffs and unemployment. Households are attempting to adjust, as best they can, to a rapid contraction in credit, threats to retirement funds and increased job insecurity. All of this implies a marked retrenchment of consumer spending as households divert an increasing part of their incomes to replenish depleted assets.

A necessary condition for this crisis to end is a stabilisation of home prices in the United States. They will stabilise and clarify the level of equity in US homes, the ultimate collateral support for much of the world's mortgage-backed securities.

At a minimum, stabilisation of home prices is still many months in the future. But when it arrives, the market freeze should begin to measurably thaw and frightened investors will take tentative steps towards re-engagement with risk. Broken market ties among banks, pension and hedge funds and all types of non-financial businesses will become re-established and our complex global economy will move forward.

Between then and now, however, to avoid severe retrenchment, banks and other financial intermediaries will need the support that only the substitution of sovereign credit for private credit can bestow. The US$700 billion (S$1 trillion) Troubled Assets Relief Programme is adequate to serve that need. Indeed the impact is already being felt. Yield spreads are narrowing.

As I wrote last March, those of us who have looked to the self-interest of lending institutions to protect shareholders' equity are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets' state of balance. If it fails, as occurred this year, market stability is undermined.

What went wrong with global economic policies that had worked so effectively for nearly four decades? The breakdown has been most apparent in the securitisation of home mortgages. The evidence strongly suggests that without the excess demand from securitisers, sub-prime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults far fewer.

But sub-prime mortgages pooled and sold as securities became subject to explosive demand from investors around the world. These mortgage-backed securities, being 'sub-prime', were originally offered at what appeared to be exceptionally high risk-adjusted market interest rates. But with US home prices still rising, delinquency and foreclosure rates were deceptively modest. To the most sophisticated investors in the world, the securities were wrongly viewed as a 'steal'.

The consequent surge in global demand for US sub-prime securities, supported by unrealistically positive rating designations by credit agencies, was the core of the problem. Demand became so aggressive that too many securitisers and lenders were able to create and sell mortgage-backed securities so quickly that they never put their shareholders' capital at risk and hence did not have the incentive to evaluate the credit quality of what they were selling.

It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets.

This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today.

When markets eventually trashed the credit agencies' rosy ratings in August last year, a blanket of uncertainty descended on the investment community. Doubt was indiscriminately cast on the pricing of securities that had any taint of sub-prime backing.

There are regulatory changes that this breakdown of competitive markets requires in order to return to stability. It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today's markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime.

The financial landscape that will greet the end of the crisis will be far different from the one that entered it little more than a year ago. Investors, chastened, will be exceptionally cautious. Structured investment vehicles and a myriad of other exotic financial instruments are not now or ever likely to find willing investors. Regrettably, also on that list are sub-prime mortgages, the market for which has virtually disappeared. Home and small business ownership are vital commitments to a community. We should seek ways to re-establish a more sustainable sub-prime mortgage market.

This crisis will pass, and America will re-emerge with a far sounder financial system.